By Oliver Treidler, CEO, TP&C and Tom-Eric Kunz, Consultant, TP&C, Berlin
Practitioners were confronted with a plethora of updates to the relevant regulations and administrative principles throughout 2020 and 2021. From the perspective of MNEs with operations in Germany, uncertainty about the impact of the new regulations on tax audits as well as an increased compliance burden are the manifestation of an increasingly challenging transfer pricing environment.
For 2022, taxpayers should thus prioritize assessing the impact of the updated regulations on their transfer pricing system. Amongst the specific areas of focus should be reviewing the classification of entities, integrating the DEMPE concept in the price-setting for intangibles, and addressing the position of German tax authorities on financial transactions. In respect to the last aspect, the question of interpreting how implicit support is reflected in the rating of a borrower for an intercompany loan was the subject of a decision by the federal fiscal court (“BFH”). As the court decision provides a first glimpse at how some of the more controversial aspects of the new regulations can be handled in day-to-day practice, taxpayers should familiarize themselves with some of the basics.
This contribution makes no claim to a complete assessment of the updated regulations but rather aims to provide taxpayers and consultants with a rough roadmap for navigating potential tax risks.[i]
State of play in Germany’s transfer pricing
The German legislator updated its foreign tax code in May 2021 and the German Federal Ministry of Finance released its administrative guidance on transfer pricing on December 3, 2020 (focus on procedural provisions) and on July 14, 2021 (focus on the application of the arm’s length principle). The new administrative principles are highly relevant for tax audits, as they constitute the rules of the game and ultimately shape the process and outcome of audits.
The new regulations replace, amongst others, the administrative principles of 1983 and the administrative principles procedures of 2005. Looking at the dates of the previous regulations illustrates that an update was, arguably, overdue to keep German regulations aligned with the post-BEPS developments. Considering that the OECD transfer pricing guidelines are now integrated as an annex to the administrative principles for transfer pricing, an immediate alignment is ensured. As the close(r) alignment with the OECD framework can be generally anticipated to facilitate a more seamless implementation of transfer pricing policies, transfer pricing practitioners should welcome this development. In respect to tax audits, it was sometimes difficult to get a German auditor to acknowledge arguments based on the OECD guidelines, as some German auditors refused to engage in arguments that were not directly based on German regulations. It can be hoped that such tales soon will become extinct.
Unfortunately, the alignment with the OECD framework was not the only noteworthy aspect of the new regulations. Most notably, compliance burdens were increased, and additional (discretionary) powers were granted to the tax authority. The respective provisions reflect the German government’s intention to allow auditors to demand comprehensive information – arguably, overemphasizing the need for transparency to counterbalance a perceived disadvantage of tax auditors because of information asymmetry.
A recent court decision could, however, strengthen the position of taxpayers, curbing some of the more overbearing implications of the new regulations. The federal fiscal court (“BFH”) points out in its decision (18.05.2021 I R 62/17) that it is contrary to general principles of experience (common sense) to neglect or challenge the taxpayer’s position of arm’s length interest rates (based on a stand-alone rating) and instead apply the same interest rate for a subordinated and unsecured loan as for a secured and senior loan by making general reference to implicit support considerations. Rather, auditors (courts) making such challenges must present contrary fact patterns to come to that conclusion (i.e., substantiate this assumption). The BFH also clarifies that arguments put forth (and substantiated) by the taxpayers are to be considered and evaluated and cannot simply be brushed aside. The court emphasized that the burden of proof for non-arm’s length behavior is on the tax authority.
That message was highly welcome. The shift of the burden of proof towards the taxpayer, however, is rooted in the updated administrative principles and will be difficult to effectively navigate in tax audit situations. While it is, in principle, established that the tax authorities bear the burden of proof, there is ample anecdotal evidence that “this principle is in practice the exception rather than the rule” (Jahn, IStR 2022, p. 130).
Complementary to the burden of proof, the principle of proportionality continues to be a focal point for taxpayers (and consultants), as it drives the decision on the scope of transfer pricing documentations and the allocation of scarce resources to identify and organize supplementary information. While the principle of proportionality is sustained in the updated regulations, an effective invocation in practice seems increasingly difficult (it tended to be already quite difficult before the update). Thus, at least for the key issues discussed below, taxpayers will be well advised to (proactively) dedicate sufficient resources.
Functional and risk analysis and entity classification
The functional and risk analysis (“FAR”) remains the heart of any transfer pricing analysis. Mirroring the focus on economic substance the OECD has championed, the importance of this analysis was a hallmark in the updates of the German regulations. Although the importance should be clear to every practitioner, it can be observed that some local files consist of “antiquated” star charts and a rather rudimentary analysis; in other words, assigning one cross or checkmark for every (sub-) function without considering the relative value added between the functions considering the business model. To be sure, star charts were explicitly accepted by the (old) administrative principles procedures (para. 3.4.11.4), but it becomes clear that the taxpayer is expected to revise (broaden) the analysis. Transfer pricing is becoming more economics-driven where the trend goes to quantification of value-added in the FAR analysis. According to the OECD (para 1.51), the value-added attributable to specific functions performed does not depend on the number of respective tasks (costs, assets), but rather on their economic significance. This implies that strategic decisions and the management of respective risks—as well as the utilization of unique and valuable intangibles—will generally outweigh a routine function, even when the performance of the latter requires a substantially larger headcount. When applying weights to differentiate the value-added attributable to specific functions, however, it is required to elaborate on applied weights and present quantitative evidence to defend them in accordance with the understanding of the business model gained from conducting interviews and presented business rationale.
Some German tax auditors show a propensity for misinterpreting (abusing) these provisions and request CbC-R-type data (headcount, tangible assets) to apply a formulaic approach to the FAR. Naturally, this approach opens the door to additional controversy as the allocation (expectation) of income between the related parties will drastically differ between a CbC-R analysis and an economic analysis delineating value-added commensurate with the OECD principle outlined above. To mitigate respective risks, taxpayers need to go beyond a mere star-chart approach and ensure that their documentation reflects a consistent narrative for the value-added creation and the contributions of the individual entities.
Importantly, the FAR is the prerequisite to derive a classification of the relevant related parties for transfer pricing purposes. Germany has always been idiosyncratic in this regard, by not only delineating the, admittedly broad, categories of an “entrepreneur” and “routine” entity (tested party) but also defining a so-called hybrid entity (an entity exhibiting characteristics of an entrepreneur as well as a routine entity). The hybrid categorization was important for German transfer pricing practitioners, as the application of the TNMM was disallowed for such entities. The German regulations were thus more restrictive compared to the OECD framework, as the identification of a tested party for TNMM purposes depended on avoiding a hybrid classification. Typical workarounds included the application of the so-called modified resale price method (which is a TNMM in disguise, as the price-setting based on a gross margin is combined with an outcome-testing on the net margin). With the release of the new administrative principles, this German idiosyncrasy has disappeared.
Again, while alignment with the OECD is welcome, the transition might prove quite tricky in some cases. This applies specifically to cases in which the hybrid classification was utilized in combination with a comparability analysis (benchmark) not applying the narrow interquartile range but rather narrowing the range by applying different statistical measures (e.g.,10th and 90th percentile). Such approaches were accepted in the old administrative principles procedure and enabled taxpayers to defend higher (lower) net margins for hybrid entities relative to routine entities (implement more flexible target margin systems). With the revision of the foreign tax act, the interquartile range became the default approach (a rebuttable assumption), and it is expected to be difficult to gain acceptance for other statistical measures in practice.
Thus, when updating local files with German involvement in 2022, taxpayers must be alert where previously a hybrid classification was utilized. A sensible narrative should be provided for a transition into one of the black or white categories of entrepreneur and routine entity. As the classification is a cornerstone of each transfer pricing system, controversies on this issue are bound to surface in German tax audits, especially in cases where a reclassification would be to the advantage of the German tax authority. One sensible way for taxpayers to approach these cases could be to more explicitly embrace the tested-party concept enshrined in the OECD framework and not unduly focus on routine vs. hybrid classifications too prominently.
Intangibles, DEMPE concept, and the hypothetical arm’s length test
The update of the administrative principles puts a strong emphasis on the so-called hypothetical arm’s length test, i.e., the concept of two (fictional) prudent business managers and the application of economic valuation techniques. In accordance with paragraph 3.12, the hypothetical arm’s length test is to be applied in lieu of traditional transfer pricing methods in case these do not yield sufficiently reliable results (e.g., because of lack of sufficient comparability). Paragraph 3.12 further stipulates that the hypothetical arm’s length test will “in principle” be applied to transactions involving any, (not just hard-to-value) intangibles, business restructurings, and transactions for which the profit-split method is applied but for which no comparable data can be identified. While the hypothetical arm’s length is most relevant to intangibles, many German auditors will not hesitate to apply it in the context of challenging the results of a TNMM.
In 2021, the definition of intangibles and the introduction of the so-called DEMPE concept (“Development, Enhancement, Maintenance, Protection, and Exploitation”) found their way into Section 1 paragraph 3c Foreign Tax Act. The DEMPE concept aims at a functional allocation of income and costs from intangibles between the related parties involved. An overall consideration of all DEMPE sub-characteristics within the DEMPE function is mandatory. The entitlement of income results from the respective value contributions within the scope of the DEMPE functions as the main factors to be considered by the individual related-party to the intangible. Thus, the legal ownership of an intangible does not entitle a claim to the residual income from the intangible. As the DEMPE concept has been established rather recently, there might be deviations in its application where it can be observed that German tax auditors tend to apply (arbitrary) formulaic approaches (see above comments on the functional and risk analysis). As stipulated in para. 3.53 of the administrative principles, a distinct FAR analysis is required for the descriptive considerations in this context. There are sufficient economical approaches available to operationalize the DEMPE concept. Irrespective of which analytical approach the taxpayer follows, however, it must be ensured that sufficiently comprehensive documentation be available to defend the applied approach (and implied working assumptions).
With regard to the application of economic methods in transfer pricing, the administrative principles refer to the “EUJTPF Report on the use of economic valuation techniques in transfer pricing” and Chapter VI of the OECD guidelines and thus focus on the so-called income-based methods. When applying income-based methods, the EUJTPF points out transparent, plausible financial planning and growth rates, and a useful life depending on legal, technological, and economic factors. Furthermore, the discount factor as a critical element—and tax effects on both the buyer and seller side—plays a relevant role in determining the economic benefits.
With the importance of intangibles in today’s businesses and the emphasis of the hypothetical arm’s length test in German administrative principles, existing documentation might require a review and extension. One sensible task would be to revisit existing CUPs applied in the context of intangibles and ensure not only conformity with the DEMPE concept (that should have been done anyway) but also stress-test the results with a hypothetical arm’s length test.
Financial transactions in the view of recent court decisions
The determination of arm’s length interest rates using the CUP method is a common international practice. It also has been used in Germany for many years. In Germany, this approach, however, has recently been challenged in tax audits, with such challenges being based on applying the (re-)financing costs of the lender instead. Such challenges were, arguably—at least initially—mostly targeted at German entities borrowing from financial holdings located in tax-advantageous locations at (seemingly) high interest rates, but were subsequently extended to loans previously thought to be inconspicuous. In such cases, auditors either determine the interest rates on the basis of the cost-plus method (cost of funds) or refer to the group rating as the decisive rating to determine the rating of the borrower. This goes hand in hand with the pronounced skepticism about rating tools and the interpretation of implicit support.
In its decisions on May 18, 2021 (I R 4/17 and I R 62/17), the BFH established, amongst others, the following guardrails: The application of the CUP method has priority over the application of the cost-plus method. This is first because the OECD considers the CUP method to be the most direct method for conducting arm’s length analysis, and in the case the cost-plus method was considered inadmissible. In addition, the CUP method can be reliably applied with respect to financing transactions because sufficiently reliable market data is available. The BFH points out that it also should be examined whether an internal CUP could be applied in the underlying case. Accordingly, it must be examined whether the external secured bank loan could not be made comparable with the unsecured intra-group transaction by making appropriate adjustments. If an internal price comparison is not possible, the feasibility of an external price comparison must be examined. The BFH considered the legal subordination of shareholder loans to be irrelevant, as this should be disregarded when applying the arm’s length principle. Therefore, the conditions of the loan in terms of non-collateralization and subordination would have to be taken into account in the context of adjustment calculations (i.e. as risk premiums on the interest rate).
Contrary to the view of the German tax authorities, in principle, the stand-alone rating of the borrower is decisive, and may be improved (up-notched) from belonging to the group (implicit support). The BFH’s statement, in line with the OECD guidelines, is particularly welcome that, starting from the stand-alone rating, an individual case analysis is required for considering the strategic importance of the company to determine whether the implicit support develops a relevance for the rating determination. When determining the rating, the fact that the algorithms of rating agencies are secret does not prevent the use of such ratings if they are a basis for credit assessment recognized by market practice. In principle, ordinary rating tools can be used even if the algorithm behind them is not known.
The BFH decision implies that the concept of the control of risk in adjunction with little or missing substance on the level of the lender cannot result in the interest rate being challenged as such if it is arm’s length. However, it is unlikely that the German tax authority will readily embrace the BFH decision and its representatives do not hesitate to express dissenting views. In view of the tax administration’s emphasis and effort devoted to these issues, one must anticipate that they will remain somewhat entrenched in their position and will continue to question the applicability of rating tools for a stand-alone rating.
In any case, for group financing companies, taxpayers must continue to examine whether a financing entity has sufficient economic substance to exercise risk-control functions or to determine whether the funds are being channeled through a substance-less entity. An aggressive approach tax authorities may use in the case of insufficient substance may even lead to the loan being reclassified as equity capital when limiting the analysis on that entity.
Conclusion
While positive developments with respect to financial transactions can be seen in the court decisions, the compliance burdens and information requests for German transfer pricing purposes are—to no surprise—at an all-time high. For existing German transfer pricing documentation, it will be necessary to consider the impact of new concepts (notably DEMPE) and be aware of the abolition of the hybrid classification. To ensure being commensurate with the arm’s length principle, the functional and risk analysis must be rock-solid and appropriately account for economic substance. In sum, we are not looking at great changes for 2022, but being (remaining) complacent could be costly when addressing the issues resulting from the updated regulations.
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Oliver Treidler is the managing director at TP&C GmbH and Tom-Eric Kunz is a consultant at TP&C GmbH in Berlin.
[i] For the purpose of this article, extensive references and footnotes for further explications were omitted.
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